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Yesterday a panel at the IMF Spring meetings covered the topics of DLT and tokenization of financial markets. The IMF’s Tobias Adrian moderated the discussion, observing there was “no lack of ambition” in the vision of the panelists.

One of the strongest rallying cries was from outgoing BIS general manager Agustín Carstens who said, that “tokenization can be the future of a financial system with a sophistication that we cannot imagine today.” He emphasized that by including programmability within the token, new types of contingent transactions become viable.

Mr Carstens also observed that countries that adopt tokenization early, especially those that might be considered backward today, could potentially leapfrog to become far more advanced, contributing to the financial wellbeing of their economies. While he pointed to India’s Aadhaar identity system, which had a profound financial inclusion impact, we’d add the more pedestrian example of ATMs.

In the early 1980s there were only 100,000 ATMs globally compared to more than three million today. Some of the first countries to adopt them at scale were emerging economies. A key reason was more advanced economies had to integrate ATMs into legacy back office systems. Emerging market banks had more rudimentary systems, so it was far easier to integrate them. Similarly, countries with less developed market infrastructures will find tokenization easier to roll out because they won’t be held back by the integration issues with legacy systems.

Meanwhile, it’s widely known that the BIS has been working on Project Agorá, a tokenized cross border payment system involving seven central banks and more than 40 private sector firms. However, Mr Carstens also revealed a new initiative, Project Pine, that incorporates wholesale CBDC, commercial bank money, and tokenized government securities in a way that facilitates monetary policy.

Open source Finternet tools

A year ago Mr Carstens outlined his vision of the Finternet which he developed with Infosys Chairman and co-founder Nandan Nilekani, who also led the Indian government department that developed Aadhaar. In much the same way as people can freely use the internet, the Finternet would enable people to transfer any financial asset, using any device, to anyone in the world.

During the IMF event, Mr Nilekani outlined the requirements to enable the vision. They are user centricity, a unified architecture that supports all types of assets, and universal availability.

In the year since releasing the Finternet paper, work has progressed on building tools to enable the vision, which he referred to as a “universal information tokenized system”. He says the tools are capable of billions of transactions on public blockchains, although he is not wedded to a particular technology. Open source tools will likely be released by the end of the year, and pilots are progressing with central banks and corporates.

The role of central banks?

Mr Carstens sees the role of central banks as steering the participation of the private sector and maintaining trust by ensuring the singleness of money and finality in payments. He also outlined a roadmap for central banks to steer tokenization into the mainstream.

This includes clearly articulating the vision and coordinating with other regulators to provide a regulatory framework. He envisions the central bank as enabling the foundational assets, which are part of the new Project Pine – wholesale CBDC, tokenized commercial bank money and tokenized government bonds. Additionally, central banks should provide the basic foundational infrastructure to ensure interoperability with the unified ledger. Finally, there’s a need for a public – private sector partnership to make the vision a reality.

Piero Cipollone, Director of the European Central Bank (ECB), outlined his vision of using tokenization to enable a capital markets union. A recent European Commission consultation gives considerable attention to tokenization as an important tool in its efforts.

However, Mr Cipollone observed that the path to mainstream tokenization is “a bumpy road and, and many things can go wrong.” He highlighted the fragmented nature of current European markets, with 41 trading venues and 27 central securities depositories. The last thing he wants is for tokenization to contribute to fragmentation. There’s also a risk that very large players could dominate tokenized markets, whereas the ECB wants to encourage competition. Another key goal is to encourage innovation, so the central bank doesn’t want to get so tied to a single technology that it might inhibit future innovation.

While fragmentation and interoperability were raised as concerns during the panel, the overall message was one of big ambition. As Mr Carstens put it, “Our imagination is the limit in terms of using tokenization to really shift the boundaries of the financial system.”

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In September 2023, Mercy Corps Ventures partnered with Fortune Credit, Shamba Network, and DIVA Technologies to launch a pilot to test the use of blockchain-powered smart contracts to deliver anticipatory cash transfers to pastoralist communities in Kenya. This innovative approach employed smart contracts to release funds when vegetation indices indicated impending drought conditions.

Pilot Outcomes and Insights

The pilot demonstrated that the use of blockchain smart contracts led to a 75% reduction in transfer costs and a 90% decrease in settlement time compared to traditional transfers. Moreover, the majority of pilot participants reported improvements in their ability to meet major unexpected expenses. For a deeper dive into the pilot findings, refer to the pilot endline report available here.

Scaling up with Ripple

Building on these promising results, Mercy Corps Ventures is collaborating with Ripple, Fortune Credit and DIVA Donate to expand the reach and efficiency of anticipatory cash transfers. The pilot will utilize Ripple’s new stablecoin, RLUSD, on Ethereum as the payout token, demonstrating its applicability in humanitarian aid and disaster relief. Additionally, the DIVA Donate protocol will utilize the FEWS NDVI dataset, and has updated the trigger computation methodology to be less susceptible to the effects of cloud cover.

“Our mission is to provide products that enhance financial inclusion but we found that some of our target customers such as pastoralists could not afford to pay the insurance premiums we charged…so we decided to seek out partners such as DIVA…, that could enable us to expand our reach to offer solutions to vulnerable populations that are largely ignored by traditional financial institutions”

 

~ Janet Kuteli | Founder & CEO — Fortune Credit

“Since the last pilot with Mercy Corps Ventures, we’ve made several improvements to our DIVA Donate platform to improve the donor experience as well as the robustness of the setup. In particular, we’ve streamlined web3 onboarding with social logins and embedded wallets, improved app performance across the board, and integrated more reliable drought trigger data. We’ve also centralized our blog and added new features like a donor leaderboard to foster transparency. We are committed to building web3-based applications that make a real-world impact.”

 

~ Wladimir Weinbender | Founder & CEO — DIVA Technologies

Call to Action

The pilot campaign has a target of $40,000 which will cover up to 500 pastoralists. Participating in the campaign is simple if you have a browser wallet funded with RLUSD on Ethereum. Just visit divadonate.xyz, connect your wallet, enter the amount you wish to contribute, click “Deposit” and confirm the transaction in your wallet.

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As part of the Bank of England’s central bank digital currency (CBDC) design phase, it explored an offline CBDC for its digital pound. At this stage it was only interested in technology issues, so it tested solutions provided by Thales, Secretarium, IDEMIA Secure Transactions, Quali-Sign and Consult Hyperion. It concluded the solutions were technically capable of delivering final payments, but found challenges relating to usability and the prevention and detection of counterfeits and double spending.

Offline usability challenges

The first challenge was that the offline and online CBDC balances are kept separate in the wallet, which users might find odd given they don’t care about the technical ramifications. Sometimes wifi outages can catch a user off guard. But if they haven’t already moved money into the offline balance, they won’t be able to use the offline functionality unless someone else pays them offline.

Offline payments tend to use secure elements either on a smartphone, a special SIM or smart cards. Given they have limited storage capacity, this caps the number of transactions that are possible before reconnecting to the network. One of the solutions tested was particularly limited on this front.

Imposing transaction limits in order to address potential risks has the side effect of impacting usability. And they are often not practical. For example, any kind of time limits are challenging because smart cards don’t have clocks. On smartphones the time on the clock might be changed. An alternative is to limit the number of transactions, if the secure element is compromised the transaction count could be manipulated. Although in that case, the CBDC has a problem anyway, because the private keys are also likely to be vulnerable.

Preventing and detecting fraud

The primary line of defense against counterfeiting and double spending is the cryptographic keys used within the secure element of the device. However, if somehow these are compromised, there’s a need to detect this has happened.

After executing a transaction offline, when the device is within wifi range it subsequently performs a reconciliation with the online ledger to highlight fraud or double spending. However, this is after the fact, so it doesn’t prevent double spending.

Devices can keep transaction records for later reconciliation. The possibilities are to keep full transaction records, partial records or no records, which renders the transactions anonymous. The Bank of England observed that without transaction records to reconcile with the online ledger, it’s not possible to detect counterfeits and double spending at all. And even when records are kept, the intermediaries need to share the records with each other for detection purposes. Various privacy preserving technologies were tested to safeguard personal information.

Additionally, the trials tested having a centralized system for uploading offline transaction data, using confidential computing to protect personal data. That allowed additional checks, including for money laundering.

The paper concluded that the trials “demonstrated that it might be technically feasible to implement an offline payment functionality for a digital pound but there are security, performance, and user experience challenges which need to be explored further.”

Hence, two major areas where work is needed is for double spending and fraud checks, and what happens if the secure element is compromised. While secure elements are widely used for payments, they are usually combined with simultaneous online checks.

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